Lehman employees' RSU claims must be subordinated to general creditors

The Second Circuit Court of Appeals has upheld the judgment of the lower court in finding that breach-of-contract claims arising out of Restricted Stock Units (RSU) awarded to Lehman Brothers employees must be subordinated to the claims of general creditors (In re Lehman Brothers Holdings, Inc., May 4, 2017, Sack, R.).

Lehman and the RSUs. In 2008, when Lehman filed for Chapter 11 bankruptcy, thousands of its employees held RSUs, which gave the employees a contingent right to own Lehman common stock at the conclusion of a five-year holding period.

The bankruptcy filing rendered the RSUs worthless, and the bankruptcy court determined that Section 510(b) of the Bankruptcy Code required subordination of the claims because they arose from the purchase or sale of securities. In the alternative, the claims had to be categorically disallowed because as equity holders, the claimants could assert only proofs of interest, not proofs of claim. The district court affirmed, and the claimants appealed.

Subordination. At the outset, the Second Circuit initially determined that the claims were not categorically disallowed as the bankruptcy court had determined because "at least some of the claims are distinct from any equity security interests the claimants may otherwise hold." Namely, the claimants asserted that Lehman breached its contractual obligation to compensate them insofar as it did not pay them the cash value of unvested RSUs. This breach-of-contract claim was distinct from the equity interest in the RSUs themselves.

To determine the subordination issue, the court turned to the analysis set forth in In re Med Diversified, Inc. (2d Cir. 2006) and In re Enron Corp. (Bankr. S.D.N.Y. 2006), and determined that the claims must be subordinated if each of the following three conditions is met: (1) RSUs are securities, (2) the claimants acquired them in a purchase, and (3) the claims for damages arise from that purchase or the asserted rescission of it.

Turning to the three conditions, the court determined that the RSUs constituted a "security" pursuant to Section 101(49)(A)(xiv) of the Bankruptcy Code, explaining that "in certain important respects, the claimants' RSUs resemble other securities specifically enumerated in subsection (A)."

The court also determined that the claimants received the RSUs through a "purchase or sale" in that they earned the units as compensation for their labor. The court noted that the term "purchase" in Section 510(b) is properly construed broadly "to include circumstances where a claimant has received equity securities in exchange for labor."

Basically, the claimants "purchased" the RSUs within the meaning of Section 510(b) by agreeing to receive them, in lieu of cash, in exchange for a portion of their labor. By agreeing to work at Lehman, the claimants "voluntarily accepted that Lehman had the discretion to pay part of their compensation in RSUs."

Finally, the court addressed whether the claims were claims for damages arising from the purchase of a security pursuant to Section 510(b), which provides that claims arising from a securities transaction must be subordinated. The court agreed that Section 510(b) applied to the claims "because they would not have arisen but for the claimants' agreement with Lehman Brothers to receive part of their compensation in the form of RSUs."

The claimants advanced a variety of theories in opposition to that conclusion, including alternative performance, restitution, and the deletion of the subordination provisions from the Lehman RSU program as evidence of the parties’ intention to treat the claimants as general creditors in the event of bankruptcy, but the court found none of the arguments to be persuasive. Notably, the court deferred to the parties’ contractual obligations in rejecting the employees’ argument that they were entitled to cash as alternative performance. The compensation plan gave Lehman the option to pay employees in cash or in RSUs, the court reasoned. Once it chose RSUs, its only obligation was to deliver stock at the end of the five-year holding period.

Holding. The Second Circuit ultimately held that the claims must be subordinated pursuant to section 510(b), which safeguards the absolute priority rule under which creditors are entitled to be paid ahead of shareholders in the distribution of corporate assets, because within the meaning of the statute the RSUs were securities, the claimants acquired them in a purchase and the claims for damages arose from that purchase or the asserted rescission thereof.